Why Is The Shale Industry Still Not Profitable?

Echoing the criticism of too much hype surrounding U.S. shale from the Saudi oil minister last week, a new report finds that shale drilling is still largely not profitable. Not only that, but costs are on the rise and drillers are pursuing “irrational production.”

Riyadh-based Al Rajhi Capital dug into the financials of a long list of U.S. shale companies, and found that “despite rising prices most firms under our study are still in losses with no signs of improvement.” The average return on asset for U.S. shale companies “is still a measly 0.8 percent,” the financial services company wrote in its report.

Moreover, the widely-publicized efficiency gains could be overstated, at least according to Al Rajhi Capital. The firm said that in the third quarter of 2017, the “average operating cost per barrel has broadly remained the same without any efficiency gains.” Not only that, but the cost of producing a barrel of oil, after factoring in the cost of spending and higher debt levels, has actually been rising quite a bit.

Shale companies often tout their rock-bottom breakeven prices, and they often use a narrowly defined metric that only includes the cost of drilling and production, leaving out all other costs. But because there are a lot of other expenses, only focusing on operating costs can be a bit misleading.

The Al Rajhi Capital report concludes that operating costs have indeed edged down over the past several years. However, a broader measure of the “cash required per barrel,” which includes other costs such as depreciation, interest expense, tax expense, and spending on drilling and exploration, reveals a more damning picture. Al Rajhi finds that this “cash required per barrel” metric has been rising for several consecutive quarters, hitting an average $64 per barrel in the third quarter of 2017. That was a period of time in which WTI traded much lower, which essentially means that the average shale player was not profitable. Related: Elon Musk Could Go Unpaid For A Decade

Not everyone is posting poor figures. Diamondback Energy and Continental Resources had breakeven prices at about $52 and $37 per barrel in the third quarter, respectively, according to the Al Rajhi report. Parsley Energy, on the other hand, saw its “cash required per barrel” price rise to nearly $100 per barrel in the third quarter.

A long list of shale companies have promised a more cautious approach this year, with an emphasis on profits. It remains to be seen if that will happen, especially given the recent run up in prices.

But Al Rajhi questions whether spending cuts will even result in a better financial position. “Even when capex declines, we are unlikely to see any sustained drop in cash flow required per barrel … due to the nature of shale production and rising interest expenses,” the Al Rajhi report concluded. In other words, cutting spending only leads to lower production, and the resulting decline in revenues will offset the benefit of lower spending. All the while, interest payments need to be made, which could be on the rise if debt levels are climbing.

One factor that has worked against some shale drillers is that the advantage of hedging future production has all but disappeared. In FY15 and FY16, the companies surveyed realized revenue gains on the order of $15 and $9 per barrel, respectively, by locking in future production at higher prices than what ended up prevailing in the market. But, that advantage has vanished. In the third quarter of 2017, the same companies only earned an extra $1 per barrel on average by hedging. Related: The Unstoppable Oil Rally

Part of the reason for that is rising oil prices, as well as a flattening of the futures curve. Indeed, recently WTI and Brent have showed a strong trend toward backwardation — in which longer-dated prices trade lower than near-term. That makes it much less attractive to lock in future production.

Al Rajhi Capital notes that more recently, shale companies ended up locking in hedges at prices that could end up being quite a bit lower than the market price, which could limit their upside exposure should prices continue to rise.

In short, the report needs to be offered as a retort against aggressive forecasts for shale production growth. Drilling is clearly on the rise and U.S. oil production is expected to increase for the foreseeable future. But the lack of profitability remains a significant problem for the shale industry.

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Just take a look at small to medium cap share prices to tell you what the market thinks about shale today. The fake metrics they promoted the market no longer falls for Investors want to see real cash flow made, which does not happen when you pursue production over profit
But CEO bonus on production growth and not profits. And Ch 11 is an American way of life. So nothing will change The natural gas companies are beyond terrible and continue to increase production, they have no one to blame but themselves

Lee James on January 29 2018 said:

The view expressed here may be the minority view. It's interesting how people can see critically important data -- information that needs to guide investment and what's best for our country -- so differently.

As we mostly go after Tier 1 prospects in a relatively small number of shale plays, I wonder what comes next. Tiers 2 & 3 remain. Especially after the Permian in TX/NM, what comes next? We are down to oil source rock. Very deep, diffusely held oil is inherently expensive to bring in -- especially if we are left holding leases on increasingly tough oil formations.

I think there's a big question mark on oil production in the U.S. I see us carrying a lot of risk. I think it reasonable that many major corporations and international banks are moving away from oil dependency. We need to transition away from oil in a wide variety of ways, as fast as we can. Our job is to figure our how fast to transition.

CorvetteKid on January 30 2018 said:

The analysis doesn't make sense. Yes, some heavily-leveraged companies which turned out to have lousy acreage went under (SandRidge). But the vast majority of shale plays are economic at $35-$40 per barrel.

Morgan Stanley recently showed that the bearish case for shale costs in 2020 was $43/bbl.; bullish case was $25/bbl. So even if you assume the worst, hard to be bearish if oil is in the $60's.

Mathmagician on February 05 2018 said:

The truth is very simple. Shale plays are going against the Second Law of Thermodynamics. Forget the financial hogwash. If serious empirical investigation were to occur to account for all of the giga Joules required to extract one barrel of oil we would discover that, at best, we break even.

EROEI folks. I don't think very many people have truly come to grips with what this means. Of course the powers that be will use all the finance tricks they know to try to keep the oil flowing. If it were to stop we would be planet mad max.

Have a nice rest of your life. Don't forget to train that cardio. All of you are going to need it.